S Corp Pass Through: Everything You Need to Know
An S corp pass through is a special business entity whose earnings, losses, deductions, and credits pass through to its shareholders' individual tax returns.3 min read
S Corp Pass Through
An S corp pass through is a special business entity whose earnings, losses, deductions, and credits pass through to its shareholders' individual tax returns.
What Is an S Corporation (S Corp)?
- An S corporation protects against double taxation, while offering the benefits of limited liability.
- For federal tax purposes, an S corporation is considered as a pass-through entity through a special status granted by the Internal Revenue Service (IRS).
- An S corporation is set up by filing Articles of Incorporation, and it has shareholders and directors to run the company just like in the case of a C corporation.
- Bank accounts and other personal assets of S corp shareholders cannot be seized to settle the business liabilities of the corporation.
- An S corporation passes through its profits and losses to its shareholders just like a sole proprietorship business or a partnership firm. Shareholders pay income taxes on their shares of income at individual tax rates.
- Unlike a regular company, where tax is first levied at the corporate level and then again at the individual level, an S corp saves you from double taxation.
S Corp Advantages
- The S corporation status is especially beneficial at the time of ownership transfer or when you decide to discontinue the business.
- Except in case of express personal guarantee, S corporation shareholders cannot be held responsible for their company's debts and liabilities.
- Unlike in partnership and sole proprietorship businesses, creditors of S corporations cannot ask to settle their debts from the personal property of shareholders.
- S corporation earnings are not subject to corporate income tax.
- S corporation shareholders can set off business losses against their personal taxable income. This can be greatly helpful during the initial years of a new business, when startup costs are higher.
- S corporation shareholders can work as employees and draw wages from the company while continuing to receive tax-free distributions on their investment.
- Employee shareholders can save on self-employment taxes while the company can claim deductions for the wages paid to them.
- Transfer of ownership in an S corporation is simple and without adverse tax impacts. In the case of standard corporations and partnership firms, transferring an interest of more than 50 percent can result in the termination of business.
- There are no complicated accounting procedures involved (like adjusting the property basis) during ownership transfer of an S corporation.
- S corporations that do not have inventory can follow a cash basis of accounting, which is far easier than the accrual method.
- Forming an S corporation gives credibility to your business.
S Corp Disadvantages
- Forming and operating an S corporation involves certain formalities and expenses, like filing Articles of Incorporation, finding a registered agent, submitting returns, and paying appropriate fees.
- Several states impose franchise taxes and annual report fees, which are not applicable to sole proprietorship businesses and partnership firms.
- Failure to comply with return filing and other obligations can result in the termination of an S corp status.
- For the purpose of taxation, an S corporation must follow a calendar year except when it has a sound business purpose to follow a fiscal year.
- An S corporation cannot offer more than one class of shares. Although it can have voting and non-voting shares at the same time, it can't assign different distribution rights to its shareholders. Additionally, it cannot have more than 100 shareholders, and there are also restrictions on foreign ownership.
- There is a closer scrutiny on payments in order to ensure that they are correctly split between dividends and salaries.
- Since there is only one type of stock, it's difficult to assign profits and losses to specific shareholders.
- It's often difficult to maintain the accumulated adjustment account (AAA).
- Most of the fringe benefits that an S corp employee-shareholder gets are taxable if the receiving shareholder has an ownership of more than two percent.
How to Start and Form an S Corp
- Reserve a name for your business.
- Prepare and file Articles of Incorporation.
- Issue share certificates to founding shareholders.
- Get licenses and certificates applicable to your business.
- Apply online or submit Form SS4 for an Employer Identification Number.
- Apply for other identification numbers applicable in your area; the most common ones include IDs for unemployment, disability, and payroll taxes.
- File Form 2553 within 75 days of forming the company.
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